A line of credit is an interesting credit facility. Basically, it is like having a credit card with a high credit limit for business purposes. The institution preapproves you for a set limit of money you can borrow. Then, you can submit a request to draw on that money and have it paid to a vendor, or deposited into your business account, or it might even be linked to an actual credit card.
It used to drive me crazy when someone would request a line of credit and say the purpose was for “working capital.” Well sure, that much is obvious. With small businesses, it tends to be a matter of having a way to separate business expenses from personal expenses. In this situation, the line of credit will not be particularly large; probably under $100,000. In this case, the line of credit is not necessarily for “working capital,” but more for documenting business expenditures.
For larger businesses, which we tend to call “commercial and industrial” or “C&I” operations, a line of credit does fulfill a distinct need of providing working capital. However, why that line of credit needs to be a source of working capital should be clearer in the request or the underwriting. Most often, these lines are used to bridge the collection of accounts receivable. In other words, a contractor has billed someone he/she provided services to, and is waiting for that bill to get paid. In the meantime, the contractor needs to start work on another contract, as well as pay their own bills for keeping the lights on. The contractor will then draw on the line of credit to pay for the things that need to be paid for today, and then pay back that line of credit when the account receivable is collected.
Another way in which a C&I operator may use a line of credit for working capital is to finance inventory. In other words, they will draw on the line to buy raw materials or wholesale products, and then pay back the draw after they have sold that inventory. This poses a much greater risk than financing receivables. An account receivable represents a completed sale; whereas, inventory is really a sale waiting to happen. There is no assured time in which it may be sold. It may never be sold. Then how would the line be repaid? This is why financing inventory is more challenging!
To make sure that lines are only drawn for the purposes of accounts receivable or inventory, the borrower must submit a borrowing base to prove these assets are present on their balance sheet. This also helps prevent the line from being used for non-working capital purposes. If a borrower has a need to have funds available like a line of credit, but will use it to purchase vehicles, equipment or machinery, we instead setup a guidance line that will convert to a term-out of the principal after a specified time. Otherwise, we would have a line of credit with a balance that never gets repaid from the sale of an asset. In this case, we say the line has permanent working capital, or is “evergreen,” since it is always outstanding.
To summarize, all lines of credit are not necessarily for the same purpose. Be sure to find the underlying need for the line of credit so you can structure it accordingly.